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Henry Paulson would take a (huge) pay cut to run the Treasury, but a key tax break will help ease the pain.

By Jeanne Sahadi, CNNMoney.com senior writer

June 26 2006: 4:18 PM EDT

NEW YORK (CNNMoney.com) -- The $183,500 salary for the Treasury Secretary post may not mean much to nominee Henry Paulson, Jr., who's used to earning closer to $40 million. But thanks to a provision in the tax code, the exiting Goldman Sachs CEO will get a financial break for moving to D.C. that could add up to millions.

But anyone who surmises that the tax break might have been one of the incentives for Paulson to take the Treasury job isn't really parsing the numbers.

Henry Paulson, the outgoing CEO of Goldman Sachs is widely expected to be confirmed as Treasury Secretary.

Paulson, who is expected to get the nod from the Senate Finance Committee as early as Tuesday, owns about $480 million worth of Goldman Sachs stock, which the White House said he would sell to avoid conflicts of interest, according to published reports.

When executive branch officials are forced to sell assets, they are allowed to defer paying the capital gains tax owed if they buy "permitted property" within 60 days of the sale.

Permitted property includes Treasury securities and a "diversified investment fund," such as a stock mutual fund if approved by the Office of Government Ethics.

Paulson will have to pay a tax on his gains eventually, but one advantage of the forced sale for any executive branch official - not just Paulson - is the same as it is with any tax-deferred vehicle, like 401(k)s: the longer you put off taxes, the larger the balance that remains invested and the faster your money can compound.

And for someone like Paulson, whose wealth is heavily tied to Goldman Sachs, it's a free way to diversify one's holdings.

We asked Mark Luscombe, principal tax analyst at CCH, and Tom Ochsenschlager, vice president of taxation at the American Institute of CPAs, to help us figure out how the provision would work to Paulson's advantage.

Assuming the cost basis on his $480 million holdings is somewhere between $50 million and $240 million, we calculated that the capital gains break might net Paulson an extra $3 million to $8 million after tax after three years. That assumes a cumulative rate of return on his investments of between 9 percent and 15 percent.

A lot of money to be sure, but not relative to Paulson's reported $700 million in net worth.

He could choose to hold on to his permitted property investments well past three years, thereby deferring his tax bill indefinitely, which could be a significant boon.

But, assuming he wants to sell at some point, waiting could cost him - the capital gains rate is scheduled to climb from 15 percent to 20 percent in 2011, narrowing or eliminating the advantage of deferring his tax bill.

The math

Here's how we did the math on our three-year scenario:

For simplicity's sake we assumed all the gains he'd realize from the sale of his Goldman stock would be long-term and taxed at 15 percent.

Without the tax break Let's assume his cost basis is as high as $240 million, making his capital gains worth $240 million. If he sells his stock today without using the tax break, he would owe $36 million in tax, leaving him with $444 million.

With the tax break But say instead he sells his stock today and invests the whole $480 million in a permitted investment for the next three years. If he gets a 9 percent cumulative return, his investment grows to $523.2 million.

His cost basis on that amount, under the tax-code provision, would still be $240 million. Hence, his capital gains would be $283.2 million on which he'd owe $42.5 million in tax. That would leave him with $481 million.

The advantage That's $37 million more than he would have if he sold his stock today and didn't take advantage of the break ($481 million minus $444 million).

But it's very possible Paulson would choose to invest that $444 million over the same three years. Assuming he gets the same 9 percent return, that would grow to $478 million after-tax - only $3 million less than what he would have if he hadn't been forced to sell his Goldman shares in the first place.

The advantage of the tax break will be greater the lower his cost basis and the higher his return. For instance, if his cost basis were just $50 million and he generates a 15 percent return over three years, he'd net an extra $8 million.

Of course, if Paulson weren't forced to sell in the first place, he might have done quite well just by keeping his Goldman shares. After all, Goldman's stock price has more than doubled since 1999. And that doesn't count the salary he's giving up.

But as all savvy investors know, stocks can fall and being so heavily invested in any one company can be risky at best, even if you're running it.

So, in essence, Paulson will be forced to diversify his holdings in a tax-advantaged way. And the real bonus is he'll get to sign every dollar of the gains he'll net from making the move.